July 23, 2016

Most economists do still not understand the current regulatory distortion of the allocation of bank credit to the real economy.

Sir, Tim Harford, when analyzing and questioning the economic arguments on Brexit writes of “the low reputation of economists, the result of a global financial crisis that only a few in the profession warned us against”, “Metropolitan myths that led to Brexit” July 23. And among “the four articles of centre-left faith” Harford brings up that of the “economists are reliably wrong”.

Yes, the economists did not warn, as they should have done, had they been interested, as they should have been. But so much worse is it that, after all the evidence of a crisis that breaks out because of excessive exposures to “safe” assets, those assets against which banks were allowed to hold very little capital, most economists do still not understand how the risk-weighted capital requirements for banks distorts the allocation of bank credit to the real economy. Or is it they just do not care? Or is it that they just do not dare to criticize?

I am just going through “Progress and Confusion: The State of Macroeconomic Policy” edited by Olivier Blanchard, Raghuram Rajan, Kenneth Rogoff and Lawrence Summers; recently published by IMF and MIT. The book has its origin in a conference organized by IMF in April 2015 titled “Rethinking Macro Policy”, the third one.

In it only Anat R. Admati refers to “distortion” and writes: “The presence of overhanging debt creates inefficiencies… In banking such distortions may result in biases in favor of speculative trading or credit card or subprime lending and against creditworthy business”.

Good for her, Admati is one of the few on the right track. Unfortunately, she has not yet fully grasped the fact that allowing banks to leverage their equity, and the support they receive from society differently, depending on ex ante perceived risks, produces a totally different set of expected risk-adjusted ROEs than those that would result without such regulatory distortion.

And the confusion between ex ante perceived risks and ex post realities persists. When Admati mentions “subprime lending” she refers to it as something risky, forgetting the risk-weights for those operations was (and is) 20 to 35%; and when she writes about “creditworthy business”, most of it was (and is) risk weighted at 100%

Frankly, all those economists who regulate banks without clearly defining the purpose of the banks, are putting a very black mark on our profession.

All risk management must begin by clearly identifying those risks we cannot afford not to take… and, in banking, we cannot afford the banks not to take the risks the real economy needs.

@PerKurowski ©